The Road to $90 Oil

Morgan Stanley’s Global Oil Strategist, Martijn Rats, says that traditional supply/demand estimates could be masking a mismatch between the supply of light oil available and demand for heavier oil needed for jet fuel, diesel oil and other middle distillates.

When oil prices plunged in 2014, some investors questioned whether the changing dynamics of global oil would keep prices suppressed indefinitely. Slowing global demand, shale and oil sands production in the U.S. and Canada, and a growing emphasis on energy alternatives were just three of the factors that put pressure on the commodity.

Current dynamics, coupled with growth in global demand for middle distillate product, suggest that the market for Brent crude will remain tight.

While geopolitical events and returning demand have helped oil prices creep higher over the last year, another aspect of oil supply and demand has been missed by many investors. Namely, the mismatch between the supply of light-grade shale oil available and demand for heavier oil needed to produce middle distillates, including jet fuel, kerosene, diesel and heating oil.

This rise in global demand coupled with other contributing factors—including regulations from the International Maritime Organization (IMO) that will limit use of high sulfur oil by shipping vessels—suggests that Brent oil prices can keep climbing, possibly reaching $90 a barrel by early 2020.

Supply and Demand More Nuanced

To arrive at their recent outlook for oil, Rats and his team looked beyond the traditional supply/demand balance. Instead, they analyzed oil as a refiner would, asking the question “Can refiners make the products we need from the oil that is available?”

Their conclusion: Middle distillate inventories in countries that report weekly are already at the bottom of their five-year range. Moreover, the new supply of oil is increasingly light and therefore results in lower yields for middle distillate product. In other words, more shale oil is needed to produce a refined product.

Meanwhile, the IMO regulations slated to go into effect in 2020 add another wrinkle to the supply/demand equation. Although shipping accounts for just 5% of global oil demand, these regulations, which require shipping vessels to use low-sulfur oil, will shift demand from one product category to another. This will likely have major implications for refiners, and hence crude demand, Rats notes.

These dynamics, coupled with continued growth in global demand for middle distillate product, suggests that the market for Brent crude will remain tight, with demand growing by 0.6 million barrels a day per year, and inventories falling.

“The key to future oil prices does not lie in broad supply-demand balances—at least not at the moment,” Rats adds. “Instead, it lies in refining economics.”

A Golden Era for Refineries

The conventional view on refinery economics has been that rising oil prices compress refinery margins. This prognosis, along with the threat of renewables, has nearly halved refining investment to below mid-cycle levels, despite a significant upswing in demand.

Indeed, global economic expansion has resulted in a 30% higher growth in petroleum product demand over the past three years than seen in the past decade.

“With jet fuel, mining, chemicals and heavy transport demand here to stay, the world is falling short by about one refinery annually until 2020,” Rats says, noting the world needs to add three refineries every year to match demand growth.

Increasing demand for diesel, particularly from emerging markets, represents a significant opportunity for refineries. “While gasoline drove the refining cycle into its silver age, we believe diesel will spearhead the transition into a golden age, as its margins look set to nearly double by 2020 from last year's average,” Rats says, adding that gradual rises in oil prices should have a limited impact on the refining cycle.

Given that it takes up to 10 years to get a new refinery up and running from the drawing board, there is little risk of a boom in refinery supply. That should lead to higher margins for existing refineries.

The bottom line for investors, says Rats: “We see the sector delivering 30% to 50% outperformance versus the major global market benchmarks over the next two years as a lack of investment drives margins higher.”